Token Incentive Systems
Incentives are a central part of economics and blockchain networks give us new ways to design and build incentive systems. As Mike Goldin, a lead engineer at ConsenSys noted “Blockchain gives us programmable money. When you can program money, you can program incentives, and when you can program incentives you can program people.” Programming people may sound a bit funny but in fact, it captures something of what is now possible. Like never before we have the capacity to rapidly build and implement large-scale structures for incentivizing human behavior towards certain ends. We are increasingly moving into a world where we can analyze, design and adjust real-world economic and social outcomes by deploying new protocols on the internet. This is a new capacity that we now have, one that offers both huge potential and is at the same time frighteningly powerful.1
How to create incentive systems that align the interest of the individual with the overall beneficial outcomes for the organization or economy is a central issue of interest in business management and economics in general. A central premise of economics is that people respond to incentives. One of the key insights of Adam Smith was that overall beneficial outcomes for society and economy should not depend upon the virtues of the individuals within the system but instead, optimal outcome should be achieved by designing incentive structures that link the individual’s self-interest with beneficial overall outcomes.
This is captured in his famous passage2 “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our necessities, but of their advantages.” This is a very important insight and history will teach us time and time again that we should not depend upon the virtues of the agents within the system if we wish for long-term stable functional outcomes. Over time the most virtuous of leaders can turn into the most brutal of dictators. The only way we can assure long-term stable outcomes is by a clear analysis and design of the incentive structures in the system. The only way we are ever going to get really functional economic systems is by really understanding the incentive structures in the network and designing those so that they are aligned with the overall desired outcomes. Every misalignment of incentives will over time turn into a dysfunctionality within the network.
The structure of the incentives within the system is critical to whether the economic system will thrive or fail. Capitalism has succeeded to a certain extent where communism failed precisely because of its incentive structure. A good illustration of this is The Jamestown Colony, the first English-speaking colony in North America founded in 1607 in Virginia. The colonists spent the first 10 years of their existence hungry, they never had enough food, with over 80-percent of the colonists perishing in what became known as the “Starving Time”.3 But then after those first ten years, the colony thrived, the colonists had plenty of food and their numbers increased and it took off. It was the same people using exactly the same techniques so what changed. Before 1615 they all went out to the field, everyone worked, and then they took the output from that field and divided it up equally. In such a system people have no incentive to work harder than the minimum required; there was no linkage between individual incentives and overall beneficial outcomes. In 1615 they made a very simple change to the rules, they divided up the farmland so that each person had their own individual plot of land. You could now do whatever you wanted with the food that you grew, they grew their own food, they ate it, they sold it to each other, they gave it to their families and the colonies thrived. It was a change in incentives that ended the starvation and brought about abundant food supplies.4
Human beings have always been bad with incentives. We get ourselves into all sorts of situations that we don’t intend because of how we try to direct groups behave. We can look a what the incentive structure that a deregulated financial system has caused, or anonymous political donations of money. The reality of how incentive systems play out in the world is complex and typically beyond the designer of the system’s capacity to foresee, as a consequence we often just lurch from one model to the next as we react to the unintended consequences of the previous system. The central aim of economies is to enable people to work together within a combined enterprise. To do this we have to align the behavior of the individual with the whole. Blockchain networks are all about protocols that enable coordination between actors. The great innovation of blockchain networks is as a new system for incentivizing a network of autonomous nodes towards maintaining a shared infrastructure. Token economics builds upon this underlying technological innovation. With tokenization, we are going to start to incorporate explicit incentive systems into more and more spheres of life. We are attempting to build these micro-economies around every source of value so as to align people’s individual incentives with delivering an overall functional ecosystem.
In every socio-economic organization, there is the opportunity for collaboration and cooperation which leads to optimal outcomes for all. There is also the opportunity for competition and conflict, which can lead to suboptimal overall outcomes and unequal pay-offs for actors. The purpose of a social or economic institution is to achieve coordination and optimal overall outcomes. Every game has two equilibria, a good equilibrium – where everybody cooperates resulting in everybody gaining – and a bad equilibrium – when nobody cooperates, nobody contributes and nobody benefits. The optimal overall equilibrium is typically very fragile. It’s enough for one person to deviate from the good strategy and the whole system can deteriorate. However, the bad equilibrium is very stable. Trust is about our ability to stay in the good equilibria.
The traditional way that we have solved this equation is through a centralized authority, which mandateds that all act according to the economically or socially beneficial outcome. Token economics attempts to achieve this alignment through peer-to-peer exchanges of value that incentivizes the actors to operate according to overall effective outcomes. To illustrate this dynamic we can think of the torrent file sharing system. In a torrent network, anyone can share their files with a decentralized group of peers. The idea was that people would download them and keep sharing them with the network for others to download. If you downloaded a file, then you were expected to seed as well. This is what we would call an honor system, which is a system operating based on honor or honesty without having strictly enforced rules governing its principles.
The problem is that humans are not always the most honorable of creatures and without any economic incentives it made no sense for people to keep seeding a file which took up unnecessary storage space and bandwidth. What token economics adds is the capacity to incentivize these peer networks. Unlike open source software, peer-to-peer file sharing or creative commons where the infrastructure is dependent upon the goodwill of the actors, tokens incentivize the peers to participate. So instead of a file storage system being dependent upon a centralized for-profit organization or people’s charitable willingness to provide the resource, it gives those members tokens to incentivize their provisioning of the resource.
The fact that tokens can be used to define and exchange any form of value means that these distributed organizations can be used to deliver all forms of services; both what has been previously delivered by private organizations but also services that have previously been the purview of the public sector. Public services like cleaning up litter, maintaining parks, public security, care for the elderly, reduction in noise pollution, civic engagement etc. Indeed anywhere value could be generated by the coordination of members, we can define a token for that value and use it to incentivize the agents towards the coordinated behavior, thus enabling the delivery of the service through peer-to-peer token markets.
The Ethereum developer Karl Floersch summarizes the current situation well when he notes.5 “Incentives drive behavior and open access to programmable incentives sets the stage for radical change. This is a really unique moment in history, this change can be good or this change can be bad, we can program incentives which promote cooperation and equitability and general happiness, everyone’s goal, or we can create incentives which prop up a few people and give them way more power than they already have. This is like kind of terrifying, so we need to design mechanisms, test them in the real world and share our findings and do that over and over on a large scale.”
1. YouTube. (2018). CESC2017 – Karl Floersch – Casper Proof of Stake. [online] Available at: https://www.youtube.com/watch?v=ycF0WFHY5kc&t=549s [Accessed 22 Mar. 2018].
2. Geolib.com. (2018). Adam Smith Wealth of Nations, Book 1 Chapter 2,Of the Principle which gives occasion to the Division of Labour. [online] Available at: http://geolib.com/smith.adam/won1-02.html [Accessed 22 Mar. 2018].
3. Encyclopediavirginia.org. (2018).Starving Time, The. [online] Available at: https://www.encyclopediavirginia.org/Starving_Time_The [Accessed 22 Mar. 2018].
4. YouTube. (2018). Only Econ episode 1: Economic Incentives. [online] Available at: https://www.youtube.com/watch?v=it0NjNlT4jo [Accessed 22 Mar. 2018].
5. YouTube. (2018). CESC2017 – Karl Floersch – Casper Proof of Stake. [online] Available at: https://www.youtube.com/watch?v=ycF0WFHY5kc&t=549s [Accessed 22 Mar. 2018].